Delinquencies peak the third and fourth years of mortgages. Will risky terms add to the problem?

By Les Christie, CNNMoney.com staff writer

March 28, 2006: 2:40 PM EST

NEW YORK (CNNMoney.com) -
Millions of mortgage borrowers are entering their "danger years," when delinquencies peak and owners risk losing their homes.

Although borrowers are often told that the first year is the hardest, delinquencies have historically reached their highest points during the third and fourth years of mortgages, according to Doug Duncan, chief economist for the Mortgage Bankers Association (MBA).

There are a few forces at play: After years of strained budgets, borrowers may have little in savings to draw on to handle a crisis; this is also the period when major repairs begin to crop up; finally, many home buyers go through life changes, including starting a family.

The number of Americans affected by the coming danger years could be huge. Half of all mortgage loans are three years old or less, according to the MBA. Nearly $3 trillion in mortgages originated in 2002, $4 trillion in 2003 and $3 trillion again in 2004. Many were refis, but there were also record totals of new purchases as well.

In addition, many of these transactions involved risky loans, such as interest-only ARMs and no-down payment loans.

A recent report from the National Association of Realtors found that the median new home buyer put down just 2 percent in 2005. Forty-three percent put down no money at all. And according to SMR Research, some 25 percent of loans were interest-only, do nothing to reduce the debt on the house.

"Lenders used to offer interest-only loans to only the best credit-quality prospects. That's no longer true," said Stuart Feldstein, founder of SMR Research.

Adjustable rate loans accounted for nearly half, by dollar volume, of loans issued in 2004 and 2005. Because interest rates have risen and are expected to increase further, those loans will adjust upward and monthly payments will be higher.

With a $200,000 loan adjusting upward from 4 percent to 6 percent, the monthly bill would increase to about $1,200 from $955.

"There are very vulnerable groups out there," says Allen Fishbein, Director of Housing and Credit Policy for the Consumer Federation of America. "We found many consumers severely underestimated what their payments would be when they adjusted. Some didn't even know how to calculate what their payments would amount to."

Most homeowners are safe

Duncan tends to downplay the perils of non-traditional mortgages. He points out that 35 percent of all homeowners carry no mortgages at all and another 50 percent have traditional fixed-rate loans, which leaves only 15 percent of all homeowners at risk.

And, he points out, some who have opted for nontraditional mortgages are affluent and choose these products to free up cash for more lucrative investments. The risk to these financially savvy individuals is low; most can pay off their mortgages any time.

Furthermore, those who bought a few years ago in hot markets may already be in safe territory, as the value of their homes has grown enough that they now have enough equity to ride out financial storms.

But even if the percentages of borrowers who may go into default remains modest, even an increase of a few percentage points can add up to millions of households.

Big price gains are ending

And housing markets seem to be headed, if not into a decline, at least into a period of much more stable, slower growth. The median home is predicted to inch up by only a few percent in 2006, according to NAR. In many markets, prices may fall. Home buyers cannot count on increasing home equity to bail them out of tight situations.

Fishbein recommends that most mortgage borrowers convert to fixed rate loans as soon as practical. "Consumers have enough uncertainty in their financial lives,' he says, "Nailing down their housing payment is a good course for most consumers."

"People are really stretched," says Dean Baker, macroeconomist and Co-Director of the Center for Economic and Policy Research. "They are banking on everything turning out right for them. That they won't lose their jobs, that they won't run into unexpected expenses. They're betting that the housing market will continue to appreciate."

"The problem is that few people recognize it for the gamble that it is," says Baker.